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Jewish World Review July 25, 2002/ 16 Menachem-Av, 5762

Lawrence Kudlow

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Consumer Reports

Pitt's revenge

http://www.NewsAndOpinion.com | It is often said that the stock market is driven by fear and greed. If greed was the dominant psychology of the market's rise in 1999 and 2000, certainly fear is the watchword for the Panic of '02.

Fear of what? Well, for CEOs and CFOs, fear of a 20-year jail term is a good place to start. New legislation now pending in Congress could mandate a 20-year prison term for something as ambiguous as "artifice and fraud," a legal penalty that could be as wide-bodied as a 350-pound offensive lineman in the NFL.

A second fear factor for top corporate execs is the SEC's new order that company financial statements must be certified for accuracy and completeness. Harvey Pitt may be the most embattled SEC commissioner in our lifetime. But with this move, he has trumped slow-moving congressional legislation with one of the most draconian new regulations in history. Call it Pitt's revenge.

Signed under oath, these new written statements must be filed on or shortly after Aug. 14, 2002. They will require CEOs and financial chiefs at 947 large companies to swear "to the best of my knowledge" that their financial statements are accurate.

Importantly, these execs could face criminal as well as civil liability if regulators find any problems in their statements. The SEC intends to make the certifications available to the public on its website.

Most top business execs I know would prefer to stay out of jail. So you can bet your bottom dollar -- or your last share of WorldCom -- that our corporate leaders will err massively on the side of conservative accounting and forecasting for all manner of revenues, expenses and profits.

Which brings us to a third fear: Investors are hyper-worried that anticipated profits from a rising economy could evaporate because of incredibly cautious accounting by under-the-gun executives. So, despite the fact that industrial production has been climbing for six straight months, verifying that the economy is definitely on the mend, now we're talking the chance of zippo profits, or even profit declines. That's what the threat of a jail term can do.

The odd part of this stock-market story is that profits in the second quarter are actually up 8 percent over last year for 233 of the S&P 500 companies that have already reported. This suggests an average earnings per share of $12.65, compared with last year's $11.23, for a rise of nearly 13 percent. But the stock market is off 29 percent from a year ago and 18 percent since the SEC's re-certification announcement of June 28. In other words, nobody in the market believes the latest profit reports because they are SEC non-certified.

While both Republican and Democratic senators keep calling for his resignation, Harvey Pitt himself is determined to cleanse the corporate mind of ethical breakdowns and prosecute any hint of dishonest accounting. Therefore, the next truly credible profit report arrives Aug. 14. Meanwhile, because of jail-time threats, investors will be worried over the prospect of big downward profit revisions.

The famous disconnect between a rising economy and falling stocks cannot possibly be resolved until we hear from the 950 or so firms that will post their newly scrubbed results on the SEC website. And Aug. 14 is just the beginning -- company documents will dribble in for several weeks after that date.

As we wait for the new results, it is worth remembering that through 10 recessions and 10 bear markets since World War II, economic recovery cycles have always delivered higher share prices. Over the long-term, there is no disconnect between the economy and the market. From 1947 through mid-year 2002, a 55-year period, inflation-adjusted economic growth in the United States registered a 3.4 percent average yearly gain. Company profits increased by 3.1 percent a year in that time. And total returns (including dividends) for the S&P 500 increased nearly 8.7 percent annually. Your money doubles about every 10 years.

It's an important lesson. In a free economy such as ours, stock markets are great wealth creators over the long run. Even now, with near zero inflation, rock-bottom interest rates, falling taxes and surging productivity, a double-dip profits recession is not likely.

Investors who can substitute faith for fear will be handsomely rewarded by investing in stocks. Though the road directly ahead may be filled with large bumps and deep potholes, Harvey Pitt's systemic corporate cleansing may yet save the system from itself.


JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.

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©2001, Lawrence Kudlow